Swiss Cheese and High Yield Covenants

What do Swiss cheese and high yield covenants1 have in common? A lot of holes!

Unfortunately for investors, the covenants are not supposed to have holes. They are meant to preserve a lender’s claim value. In this note, we wanted to hash out why covenants are important and why should investors care about them.

Why should you care about covenants?

The looser covenant structures that we see today will likely have two major consequences for investors. They will create “zombie” companies as management teams and sponsors utilize every flexibility under covenant terms to extend the lifespan of a company at a time of financial stress. This, in turn, will result in lower recovery rates than what investors have experienced historically. High yield spreads will widen to anticipate these credit events while the reported default rate may remain low. Many investors focus on the default rate to asses the health of the high yield market, therefore some caution will be warranted before reaching an investment view. Be careful about judging a book by its cover.

Covenant quality continues to deteriorate.

QE and the subsequent reach for yield have been a strong tailwind for the High Yield Market. Investors in their quest to acquire “higher” yield, have traded off covenant protections. Moody’s Covenant Quality Index ( see Chart 1) is at all time weak levels – ie less protective covenants. The trend of watered down covenants is not just applicable to the US HY market; European and Emerging HY Markets also exhibit the same trends. In our view, the seeds for lower bond holder recovery and more price volatility at the next credit cycle have been sown.

Chart: 1 Covenant quality at all time lows

Source: Credit Suisse, Moody’s

High Yield covenants explained

There are five key covenants that we believe a typical high yield bond investor will care about:

Limitation on incurrence of additional debt – this restricts an issuer from incremental borrowing beyond a certain level. Higher levels of debt may impact potential recoveries for note holders should the issuer becomes unable to service its debt and file for bankruptcy.